Commentary

In this shared blog, David Weisberger says a recent WSJ article is wrong and that traders do need to purchase faster and more comprehensive market data to avoid being fined for violating "Best Execution" obligations.

The Short Sale Ballgame

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The Short Sale Ballgame

The Securities and Exchange Commission, in a proposal published last fall, took another crack at reforming short selling. If approved, Reg SHO would apply a uniform "plus bid" test - without a market maker exemption - to both listed and Nasdaq securities. In addition, Reg SHO would exempt a sample of liquid names - a third of the Russell 1000 - for a two-year pilot period. Is Reg SHO another Derek Jeter or a Mario Mendoza? Is it a jewel or a bow wow?

Here's my scouting report based on three market structure "tools."

Market Quality. In the proposal, the SEC says "short selling provides the market with at least two important benefits: market liquidity and pricing efficiency." In other words, short sellers can contribute to market quality, including a price discovery check against "irrational exuberance." Costly constraints to short selling, then, can be counterproductive.

Here, Reg SHO offers mixed performance. Repealing the tick and bid tests for liquid stocks is a good idea whose time has come. Replacing the "up bid" with a "plus bid" test for Nasdaq names, however, is debatable. A "plus bid" approach means that a short sell order can't be marketable; for mid- to low-volume names, the waiting will be the hardest part. Should Reg SHO hurl this type of shutout? Does this work?

Uniformity. Today's dugout - the trading regs - are filled with exemptions known to crafty veterans of short selling. Reg SHO changes two of the biggest: the bid test exemptions for Nasdaq equities and options market makers. Although Reg SHO retains minor market making exemptions, such as riskless principal and Manning-related shorts, these changes are welcome. With hedge funds and proprietary traders providing substantial liquidity in today's trading game, special rights for market makers make less and less sense.

Intermarket Competition. In March 2003, ArcaEx launched its Nasdaq product without a bid test for shorts. Despite catcalls of "regulatory arbitrage," a uniform approach helped ArcaEx boost market share to 20 percent from 12 percent by July. Under Reg SHO, ArcaEx and others would no longer be able to innovate in this way, but the point has been made. Market structure design can be a paradox: Standardization across markets increases ease of use, but decreases innovation due to intermarket competition.

Reg SHO strikes the proper balance. In addition, Reg SHO promotes competition through its move to a consolidated bid test for listed names, as opposed to a choice of tick test. Today, NYSE operates within the friendly confines of its own tape for tick test purposes. Under Reg SHO, the exchange will use the consolidated bid, which can be driven by off-exchange quotes. Given the tendency of the exchange to fumble incoming trade-through complaints, this transition will be fun to watch.